All eyes on the dragon’s high-wire act

Hard landing? Soft landing? Bumpy landing? Australian investors and resource industry executives who have ridden the “China boom" will be hoping Beijing can steer the world’s second largest economy to a “soft landing" as policymakers tap the brakes on growth in the hope of slowing accelerating inflation.

Those hopes for slower growth and tamer inflation haven’t worked out as planned – yet.

While various indicators show China’s economy has slowed due to tighter policy aimed at dampening inflation, price pressures have done the opposite – they have gathered pace and appear set to move higher.

Inflation rose at a year-on-year pace of 5.5 per cent in May, the highest level since July 2008. It had been 5.3 per cent in April.

The pace of inflation has exceeded the government’s 4 per cent target every month so far this year.

Worse still, there have been forecasts for the pace of inflation to move higher in June, possibly as high as 6 per cent as key foodstuffs like pork – a key staple of the Chinese diet – has risen to new highs.

Even the National Development and Reform Commission, the country’s top economic planner, warned late last month inflation will “remain elevated for some months".

Premier Wen Jiabao outlined the 4 per cent target at the National People’s Congress in early March as he pledged to make fighting inflation the government’s top economic priority of the year.

Related Quotes

Company Profile

The credibility of the inflation target is in tatters and even Wen appeared to be backing away from it given comments made on his recent whistlestop tour through Europe.

“I see difficulties in reaching the full year inflation target of 4 per cent.

“But it still can be kept below 5 per cent after the efforts we have made," he said in London.

Most economists believe inflationary pressures will moderate in the second half of the year in response to the government’s tightening measures. Additionally, food prices are expected to moderate as crops recover from a drought in key grain growing provinces.

The People’s Bank of China has implemented a range of initiatives to slow growth and tame inflation.

Interest rates have been raised four times since October and the bank reserve ratio requirement (RRR) has been raised to a record 21.5 per cent for large banks.

While most economists are fairly confident about a pullback in price pressures in the second half of the year, many believe the central bank will lift interest rates maybe once more.

It is expected the PBoC will continue to raise the RRR as a tool to combat inflation as it stems bank lending by forcing them to put more capital to one side.

But Beijing faces a number of complications in its bid to tame inflation through interest rate rises and higher RRRs.

Most economists believe there is a slim chance of a “hard landing" marked by a dramatic slowdown in growth. Beijing is viewed as having the financial muscle and control to quickly stimulate the economy if growth slowed to a pace that threatened social stability.

Plans to build 10 million affordable housing units, as well as the continued build-out of infrastructure, are likely to support growth.

Most forecasters have pencilled in growth above 9 per cent for the year and government is targeting 8 per cent.

However, the use of tighter policy doesn’t preclude a bumpy landing for the Chinese economy.

Policymakers face a number of hurdles in their fight against inflation.

Stricter capital requirements have put a squeeze on lending to small and medium-sized enterprises, a source of jobs for many workers.

They have also forced banks, facing a potential increase in bad loans, to earn a lower return on their funds by keeping them at the central bank.

Higher interest rates are pressuring local governments that took on huge debts to fund major developments to support growth and jobs during the financial crisis.

Vanity projects, empty apartments and roads to nowhere have all been funded by debt and many local governments do not have the capacity to pay back those loans.

Local governments have also been hurt by Beijing’s attempts to cool the red hot property market.

Land sales, a major source of revenue for local governments, have slowed at a time when many are facing high debt repayments.

The consensus view is that China’s property bubble won’t burst.

However, there is the risk cash-strapped developers unable to access cheap and easy funding may start cutting prices, while recent speculators who have entered the market may be spooked by any weakness.

While tighter policy may be the right choice in terms of fighting inflation and rebalancing the economy, it risks straining pressure points in the economy and financial system.

Stability is the ultimate policy of the Chinese government.

That means the focus will most likely remain on short-term stability through policies targeting growth and jobs but at the risk of ignoring much-needed structural changes that may lead to instability in the future.